BANKING STRATEGY

AN INTRODUCTION

BANKING TRENDS IN INDIA

While England witnessed a process of deregulation of the financial system at the beginning of 1970s, India moved in the opposite directions bank nationalization

Indias global integration started in the beginning of 1990s

FINANCIAL SECTOR REFORMS

Narasimhan Committee recommended sweeping changes regarded as landmarks in Indian banking history

3-fold Objectives of the Reform Package

1. Liberalization of all markets by quickening the process of deregulation 2. Increasing competitiveness in all spheres of economic activity 3. Ensuring financial/fiscal discipline in all economic agents public/private sector

What makes it complicated? What are the tasks?

1. It has to make an intelligent assessment of the economic performance of others (borrowers) in matching current borrowings with the future stream of income flows

2. The enormity of this responsibility is so high, that it has always been difficult for banking industry to pressure the objective of profit maximization as jealously as the other industries

DECLINE OF TRADITIONAL BANK

1. Livening up of the capital market led to the decline of the importance of banks & financial institutions as intermediaries

2. Pressure from liability side of the balance sheet, or liberalization of the financial system has tremendous influence on the expanse & depth of the market

Competition
Bank as a lender faces:
Emergence of institutions like mutual funds, corporate with high credit worthiness can access:
Bonds, commercial paper, derivative financial products Accessibility itself creates a competitive edge for them to bargain for funds from the banks & FIs often at a lower rate than PLRs

Competition (contd.)
From the liability side of the banks balance sheet:
A number of savings & investment institutions have come up, with a large range of financial instruments as alternatives to bank deposits Competition is so intense, that interest rates ceiling being almost removed

OFF BALANCE SHEET BUSINESS

With mounting competitive pressures to enhance earnings, and
Traditional bread & butter market no longer in a position to sustain banking structure in the era of deregulation & globalization dismantling of cartels for interest rate determination or withdrawal of administered rate regime A number of well-known international banks suffered heavily, because of mismanagement of risks

 Due to all these factors commercial banking is now moving down to 3rd position with investment banking & asset management moving up

 The accent is now on off-balance sheet business, or sweeteners

Financial innovation concentrating heavily on developing these Total volume of off-balance sheet transactions is many times more than balance sheet assets of major international banks

 The reward in off-balance sheet transactions is high but they are not risk free
The Basle Committee have brought them within the framework of capital adequacy norms:
decision parameters for direct lending decisions should be the same as off-balance sheet items, because of similar types of risk exposure

CHANGING SAVINGS & INVESTMENT BEHAVIOR

The relationship between the level of income & personal savings appears to be non-linear in nature, with the largest increase in savings rate occurring in the transition from low-income status to low- middle-income status; rate of increase falls in the subsequent transition to upper middle-income, & tapers off while moving to upper-income status

Raising domestic saving rates not successful Attempts to induce savings by raising domestic interest rates not very successful in developing countries like India, where income distribution is skewed

This aspect often missed by banks of newly liberalized developing countries, where interest rate ceilings have been removed, like India:
No significant increase in deposits Rising government expenditure, leading to shortage of money supply, explains the need for mad rush

Competition intensifies around liquidity

As the market for financial instruments becomes broad-based & deep, competition intensifies around liquidity

LIQUIDITY NEWLY DEFINED

The need for liquidity has now been broadened to include, besides the precautionary motive, the investment motive as well:
Defined nowadays as the motive to quickly shifting the portfolio to alternative investment opportunities

Change in outlook
Liquidity itself has undergone an outlook change:
Traditional means of satisfaction of liquidity claims was a cost in the form of idle balances, & constrained economic allocation of resources Now it is access to liquidity that matters more than liquidity per se

Liquidity (contd.)
With liquidity mostly taken care of by providing access to it, every economic entity (household or corporate) now has the opportunity to become investment manager:
o Every company now has full fledged treasury department organized as a profit centre

Changing roles
When corporate are thus becoming banks, banks themselves are becoming corporate, motive force being changing concept of liquidity:
Liberalization has helped the emergence of increasingly active wholesale fund market, both call money & certificates of deposits markets are almost completely deregulated & broadened to include new players Most often than not liability selling gains precedence over deposit mobilization

SECURITIZATION
On the asset side of the balance sheet, banks are attempting to liquefy their loan portfolios through a process now universally known as securitization. The concept in practice in different markets:
In US, important rating agencies like Moody & Standard & Poors are rating bank loans to pave the way for the emergence of an effective loan market

In India
In India, non-banking financial companies first started the process of securitization Till recently, unlike bonds & equities, loans generally have not been traded, except to a limited extent, through participatory certificates & syndication The age-old concept of relationship banking that demands a bank to hold the loan on its books is being replaced gradually by fee-based banking, because of:
o the sheer pressure of competition, & o the need to keep the balance sheet in a liquid form in an uncertain financial environment

Securitization is the process of removing the hitherto untraded loan assets from a banks balance sheet, packaging them in a convenient form & selling the packaged securities in a financial market

RBIS perspective
RBI defines securitization as a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment
Securitization thus follows a 2-stage process:
o Stage I: there is a sale of single asset or pooling , & the sale of a pool of assets to a bankruptcy remote SPV in return for an immediate cash payment o Stage II: there is a repackaging & selling of security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable debt securities

Securitization in US & Europe

Securitization is widespread in mortgage loans, automobile loans, & leasing transactions in US & major parts of Europe:
A secondary loan market, which had almost been unheard of even a decade ago, has already become a reality in mature financial markets Even emerging markets of Asia have not lagged behind with speeding up of the process of liberalization & global integration

Creditworthiness Central to Securitization

Growth of healthy securitization loan market is dependent on creditworthiness of both original borrower & lender. However, without installation of a proper appraisal system loan market would downgrade itself to a trading center for distressed loans:
Signs were already available in the US in 1995:
o About half the loans were distressed, but no lessons were learnt

2008 -09 financial crisis, originating in US, is ascribed to securitization of mostly bad loans through esoteric instruments & palming them off to unsuspecting buyers of large banks

RBI s Guidelines
1. A bank, on an ongoing basis, have a comprehensive understanding of the risk characteristics of its individual securitization exposures

RBI s Guidelines contd.

2. Banks must be able to access performance information on the underlying pools on an ongoing basis in a timely manner

RBI s Guidelines Contd.

3. A bank must have a thorough understanding of all structural features of a securitized transaction that would materially impact the performance of the banks exposure to the transaction

S E C U R I T I Z AT I O N I S T O M A K E BALANCE SHEET LIQUID BY BRINGING THE LOAN ASSETS TO THE MARKET PLACE

STRATEGIC PLANNING
Strategies of a banking organization must undergo radical changes to attain the following broad objectives:
1. Maximizing profits both in the short- and longterm 2. Maintaining an adequate capital base for growth & regulatory requirements 3. Conducting the lending function within a managed risk framework

Profit maximization key aim of all bankers

The history of banking, at least at US & Great Britain, has seen large shifts between assets in response to movements in differentials among rates of return Unfortunately, the profit motive of a banking organization is berated by economists, who claim that the standard theory of the firm is not applicable to banks, joined by social scientists & politicians, warn that it is too dangerous to allow the profit motive to take control of banks, because it has the potential to destroy the socioeconomic fabric of the nation

Regarded as evil
The history of banking shows that banking organizations are regarded as something more than necessary evil; they are always ready to substitute profit for sound banking, which brings to naught all measures of monetary & fiscal control

In support of profit motive

But profit motive has been so strong among banking organizations, that inspite of a growing assemblage of laws & regulations, bankers have pursued it, though not always overtly, by bypassing the regulation The large scale spurt in financial innovations during the 1970s & 1980s was largely to circumvent regulations Empirical studies on the monetary history of nations have revealed the monetary expansion & consequent inflation have largely been due not to the credit creation capacity of the banks, but to the unbridled power of government to print money for ill conceived & often wasteful public expenditure

THE PARADIGM THAT BANKING SERVICES ARE NOTHING BUT PRODUCTS, WHICH ARE SOLD FOR MAKING PROFITS, MAY STILL TAKE A LONG TIME TO BE ESTABLISHED

RETURN OF THE PROFIT MOTIVE

In India, for more than two decades since 1969 when major banks were nationalized, profit was relegated to low position of importance:
Attention shifted so much to the directed sectoral deployment of credit that profit as a the ultimate sustaining mechanism of commercial banks was almost forgotten

In 1993 -95, Rs 10, 987.12 crore of recapitalization funds were pumped into the nationalized banking sector

Deregulation
Financial sector reforms with the laudable objectives of deregulation of interest rates, dismantling of directed credit, reforming the banking system, & improving the functioning of capital market, were introduced in mid1991 to usher in a second banking revolution

Profit as central focus

Profit now being the central focus of the banking organizations, and liquidity being newly defined as access to liquidity, strategic planning for a bank planning for a bank has almost taken an about turn:
So far, approach was to move from the opposite side of the balance sheet, i.e., Deposits Assets Profit Now it is Profit Assets Deposits Other sub-goals arise from profit planning

Proactive Strategic Planning

Strategic planning in banks now being essentially proactive in nature (no longer reactive to the level of deposits), a bank having decided a particularly profit target would a bank having decided a particular profit target would next move to planning of assets under 3 broad categories:
1. Statutory (CRR & SLR) investments 2. Directed (priority sector & exports), & 3. Discretionary (commercial, industry, & trade & market investments) In the final stage, funds planning would essentially be a matched process both in terms of maturity to take care of the liquidity demand, & average cost to ensure a net return to satisfy the profit target

Outcome of capital planning

Targeted profit, both in the short- and mediumterm of modern banking organization should be the outcome of capital planning & dividend policy:
Most important component of profit planning is loan pricing, which operationalises the profit target of the bank
o Strategic plan so prepared will then give rise to the formulation of the loan policy document

CAPITAL PLANNING
The function of capital in banks & other financial institutions is claimed to be substantially different from that in most other business enterprises:
In manufacturing concerns, the capital fund is used primarily for acquisition of fixed assets, in banking primarily to provide guarantee
Its usage in the acquisition of fixed assets is hardly more than 15% (never exceeds 20%)

Capital forms a guarantee function in other enterprises too, but not so predominantly

 Basle Committee holds that besides deposits, a bank has to have the confidence of the supervisory authorities about the: general health of the bank to withstand shocks of:
o Borrowers , that the bank would be in a position to meet their credit needs in both bad times & good, & o General Public, that the most important institution of the economy is functioning

Basle Committees Requirement

The confidence is ascribed to the capital funds of banks & financial institutions:
o With debt equity ratio of more than 10, how much confidence capital can provide is doubtful

GROWTH CAPITAL & DIVIDEND POLICY

Capital plan of a banking organization is a bridge between its strategic plan & profit plan:
Though there are quite a few ways to increase capital, such as selling additional shares or reducing the growth The most effective & desirable long term solution is by internal accruals in in the form of retained earnings in various reserves:
o More so because the history of the world banking in the past 60 years has shown that capital in the form of additional equity is hard to come by, may be because of:
low earnings per share (EPS), & Capital appreciation of bank shares in the stock market as compared to the shares of other companies

o Chances of improvement remote, increasing dependence on internal accrual

What should be the adequate amount of capital? There is an inverse relationship between a banks capital & its earning capacity given by earning leverage (EL): EL = Amount of assets in the bank
Amount of capital Example: Suppose the bank has a capital to asset ratio of 6% at present, which seeks to raise to 8% by issue of shares, its earning leverage will immediately fall by 23.52 %, seen from table below Table 1.0: Efects of New Capital Issue on Earning Capacity
Capital Issues Before New Issues Assets 100 Deposits 94 Capital 6 Earning leverage 16.67 After New Issues Percentage change 102 +2 94 0 8 +33.33 12.75 -- 23.52

Capital does not increase earning power of banks

Because of above, problem mis compounded, it does not increase earning power of banks by, say investing in plant & machinery as in manufacturing.
Capital adequacy norms prescribed by Basle Committee are arbitrary as they do not pay much attention to the earnings leverage:
o When capital is raised from the market, let the markets determine the adequacy of capital in banking organizations within its risk-return framework

CAPITAL GROWTH & DIVIDENT POLICY

There are only 2 ways to increase the level of Tier I capital of a banking organization:
o By issuing new shares, & o By retained earnings

In India, PSBs are now allowed to raise capital from the market, as long as govt. holds controlling shares, and except a few all PSBs have gone public

Retailed earnings
History of banks is indicative that bank capital has been built around retained earnings
o Internally funded capital is always superior to selling shares

o But, at the same time, banking organizations must ready itself for access to capital market in an environment of market propelled growth & competition

Adequate capital
From the viewpoint of shareholders, it is just as important not to have too much capital, as it is essential, from the viewpoint of safety & growth, to have enough:
If the policy is to keep the bank under tight control, minimum dividend & maximum retention could be the possible choice

Payout ratio
In India, a middle-of-the-road policy is being advocated for ownership of bank shares

After the Basle Accord, a lower payout ratio of 30 - 40 % (earlier 50%), with a minimum benchmark of 20%, is being thought to be reasonable

GROWTH MODEL
Growth (G) of a banking organization depends upon the following relation: o G = Average Assets X Net Income X (1 dividend payout) Average Capital Average Assets Although the model can ordinarily be reduced to: o Net Income X (1 Dividend payout ratio) Average Capital The purpose of showing it in the extended form is to draw attention to the 3 ratios separately for the purpose of evaluating their properties Ist ratio on the right hand side: capital requirements for asset growth is acting as a constraint: o Numerator & denominator so related that maneuverability of this ratio is very difficult

Next 2 - ratios
Next 2-ratios: have a greater scope of maneuverability, because the variables that have gone into making these ratios are capable of being handled independent of each other :
Net income can be increased by placing the lendable assets in an appropriately higher risk-return category & funding be low-cost deposits Managerial discretion is larger in case of dividend pay-out ratios

An example
Growth variables of a bank (Rs crores)
Assets : Rs 11250 Capital: Rs 900 (or 8 %) Net Income (PAT): Rs 100 Dividend pay-out ratio = 35% The bank can grow at:
o G = 11250/900 X 100/11250 X (1 -.35) o Or, .0722, or 7.22%

Given a capital adequacy norm of 8%, a return on assets of 100/11250 = 0.89%. A dividend payout ratio of 35%, the bank can grow only at 7.22%

Assume next year

Assets grew by 7.22% to Rs 12062 crore Net income @.89 % on assets = Rs 107.22 crore Dividend payout ratio remains @ 35% Hence: 0.072 2= 107.22/Capital X 0.65 Or 0.0722 = 107.22 X Capital = 69.693/0.0722

= Rs 965 crore, which is 8% of projected assets of next year

It may be seen that

Right hand side of equation (1.1) consists of is: Reciprocal of capital asset ratio (C ) Return on assets ( R ) Denoting dividend pay out ratio as D, equation (1.1) can be rewritten: G = 1/C X R X (1 D ) Or, G = R/C X (1 D) ------ (1.2)

If bank desires to grow at required capital growth To grow @ required rate of 8 % instead of 7.22%:
It has to increase R, or Reduce D Or, adjust by a trade-off

Setting the growth rate (G) @ 8 %, & keeping D constant, required R will be as follows:
.08 = R/.08 X (1 0.35) Or, 0.65 R = 0.08 X 0.08 Or, R = 0.00985 or, 0.985%

Reduce D
Now, keeping R constant & setting the growth rate @ 8% as before, required change in D will be:
.08 = 0.0089/.08 X (1 D) Or, 0.0089b (1 D) = 0.08 X 0.08 Or, (1 D) = 0.72 Or, D = 0.28

Thus bank has to reduce from 35% payout to 28% to achieve growth rate of 8%

Retained earnings
Finally, multiplying R with (1 D) gives rise to a new ratio, namely retained earnings as % of assets, which we denote as E In its shortest form, equation (1.2) will now look like: G = E/C ---- (1.3)

E can be derived as
E = (Net Income)/ (Average Assets) X (1 D) Or, E = 100/ 11250 X (1 0.35) Or, E = 0.005777 Or, E = 0.578 % Now C remaining the same @ 8%, the growth rate G will be: G = 0.005777/ 0.08 = 0.07222 or 7.22%